4 options to address the eurozone's stock and flow imbalances the rising risk of a disorderly break-up - november 1 2011 (1)

ECONOMIC RESEARCH 1

November 1, 2011

Four Options to Address the Stock and
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Flow Imbalances: The Rising Risk of a Disorderly
Break-‐Up
By Nouriel Roubini

The latest eurozone (EZ) rescue package starts to deal with some but not all of the stock imbalances
(large and potentially unsustainable debt levels in the public and private sectors) between the core
and periphery of the bloc, but does not address the serious flow imbalances (lack of growth and
competitiveness and large current account and fiscal deficits in the periphery) and, as such, will not
.

The package fails to recognize that the restoration of growth and competitiveness are the key to
success as they make stocks of liabilities more sustainable and reduce flow imbalances (such as
current account and fiscal deficits); in fact, the proposals heighten the risk of a deeper and longer
recession. Thus, financial engineering alone is bound to fail, as markets started to recognize soon
after the new plan was announced.

Stock and flow problems can be addressed with a variety of policy tools. Stock imbalances can be
addressed via growth, higher savings, inflation/depreciation or debt reduction/conversion into
equity. Flow imbalances require policies that lead to the reduction of fiscal and current account
deficits and the restoration of competitiveness and growth. The reduction of large current account
deficits requires both expenditure reduction (relative to income) and expenditure switching via real
depreciation. Such real depreciation can be achieved via: Nominal depreciation of the euro; structural
policies that increase productivity growth above wage growth and thus reduce unit labor costs;
deflation via a reduction of nominal wages and prices; or exit from the monetary union and a return
to national currencies. The restoration of growth is conditional on the restoration of competitiveness
and other macro policies (monetary easing; a weaker currency; and fiscal easing in the core) to
restore growth in the short run as fiscal austerity and reforms have a negative short-‐run effect on
output.

We identify four possible sets of policy options for the EZ to address its stock and flow problems:

o 1) Growth and competiveness are restored (through aggressive monetary easing, a much
weaker euro and fiscal easing in the core, while the periphery undergoes painful fiscal
austerity and structural reforms) and the monetary union survives for most members, with
debt reductions being the exception rather than the rule;

o 2) A deflationary/depressionary adjustment in tandem with painful structural reforms that
becomes, for some member states, socially unsustainable as growth is depressed for many
years and growth and competitiveness are restored too late;

o 3) The core permanently subsidizes the periphery via both debt reduction and unilateral
transfers that take the form of a transfer union to avoid break-‐up if the periphery is stuck in
an outcome of permanent stagnation and loss of competitiveness;

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ECONOMIC RESEARCH 2

o 4) The EZ sees widespread debt restructurings/reductions to reduce unsustainable stocks of
debt and eventually breaks up to restore competitiveness and flow balances via a return to
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national currencies.

These four policy options recent three main scenarios for the EZ:

o Scenario 1 (everything goes according to plan, so Italy and Spain grow again and are once
more able to borrow at affordable spreads without official support; to which we assign a
40% probability) is, in our view, likely to succeed only if Option 1 (macro policy reflation of
the EZ) is implemented soon; but Germany, the EZ core and the ECB want to achieve
Scenario 1 by implementing Option 2 (deflation, austerity and reforms), which will only lead
to entrenched recession for many years and a backlash against this draconian adjustment.

o Scenario 2 (kick the can, but hit a wall in 12 months as Spain, Italy and other fragile

affordable sovereign spreads; 50% probability) is reached if the recessionary and
deflationary Option 2 is pursued; however, pursuit of Option 2 could also lead to Scenario 3.

o Scenario 3 (kick the can and it explodes as Greece collapses in a disorderly fashion before
Italy and Spain are given the time to resolve their illiquidity, solvency and growth problems;
10% probability) is analogous to Option 4 (widespread debt restructurings/reductions and
break-‐up of the EZ).

Option 4 (debt reductions and EZ break-‐up) is also the outcome of this policy if the pursuit of Option
2 (favored by Germany, the core and the ECB) fails and Option 1 (macro reflation) is then not
attempted, while Option 3 (permanent subsidy by the core of a depressed uncompetitive periphery)
turns out to be politically unfeasible. Then, debt reductions and exit from the EZ across the periphery
become the most likely outcome, i.e. a break-‐up of the EZ.

So, in terms of this non-‐linear set of scenarios, the periphery will push for Options 1 or 3 as a way to
avoid Option 4; but if Germany/the core/the ECB stick with Option 2, Scenarios 2 or 3 rather than 1
will materialize and the EZ will eventually end up with Option 4, i.e. debt reductions, exit from the
monetary union and the break-‐up of the monetary union. We are of the view that, unless Option 2 is
abandoned and Option 1 is soon adopted, a vicious and ever-‐deepening recession will envelope both
the periphery and the core of the EZ and a disorderly break-‐up will gradually occur as first private and
public debts are coercively reduced and next a growing number of EZ countries exit the union.

Among the six EZ countries in trouble so far (Greece, Portugal, Ireland, Cyprus, Spain and Italy), a
subset of them will experience restructurings and reductions of their public and private debts as a
way to resolve their stock imbalances. And a different subset of these six countries may also
eventually decide to exit the EZ to resolve their flow imbalances. If enough of them coercively reduce
their debts and exit the monetary union, the EZ will effectively break-‐up over time, in a slow motion
train wreck.

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ECONOMIC RESEARCH 3

The announcement of the most recent EZ rescue package (acceptance of a bigger haircut for Greek private
creditors, the recapitalization of EZ banks and the use of guarantees and financial leverage in the hope of
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preventing Italy and Spain losing market access) led to markets rallying for a day as the tail risk of a disorderly
situation in the EZ, temporarily, diminished. By the next day, Italian yields and spreads were still close to their high,
serving as a reminder as we argued in The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the
Crisis?, co-‐authored with Megan Greene that the fundamental problems will not be resolved by this trio of
policy actions.

To put the latest package in context, we need to first assess the fundamental problems facing the EZ and the
potential scenarios for the monetary union.

EZ Flow Problems

The EZ suffers from both stock and flow problems, which are related to each other. The flow problems were
and/or are:

Large fiscal and current account deficits in most members of the EZ periphery (Greece, Ireland,
Portugal, Cyprus, Spain and Italy);
Economic weakness, manifesting itself in renewed near recession or outright recession and weak
actual and potential growth;
The long-‐term loss of competitiveness, driven by three factors: Loss of export market
share to emerging markets (EMs) in traditional labor-‐intensive low-‐valued-‐added sectors; real
appreciation, driven by wages growing more than productivity since the inception of the EZ; and the
relative strength of the value of the euro in the past decade.

EZ Stock Problems

The stock problems are the large and possibly unsustainable stock of liabilities of: The government (in most of the
periphery with the exception of Spain); the private non-‐financial sector (mostly in Spain, Ireland and Portugal); the
banking and financial system (in most of the periphery); and the country (external debt), especially in Greece,
Spain, Portugal, Cyprus and Ireland.

Stock vulnerabilities are the result of flow imbalances: A big fiscal deficit results in a growing and large stock of
public debt (Greece, Italy, Ireland, Cyprus, Portugal) and in a large stock of foreign debt when private sector
savings-‐investment imbalances are also large; a wide current account deficit whether driven by private sector
imbalances (like in Spain and Ireland) or public sector ones (Greece, Cyprus, Portugal) leads to a build-‐up of
foreign debt. In some cases, the excesses started in the private sector (housing boom and then bust in Ireland and
Spain); so, initially it was a buildup of private debts and of foreign debts driven by large current account deficits. In
other cases, the excesses started in the public sector (Greece, Italy, Portugal, Cyprus), leading to a large stock of
public debt and of foreign debt via current account deficits in the subset of countries with fragile savings-‐
investment imbalances in their private sectors (Greece, Portugal, Cyprus).

Until recently, Italy had a public debt problem but not current account and foreign debt problems as the high
savings of the household sector prevented the fiscal deficit from turning into a current account deficit. But now,
the sharp fall in private savings has led to the emergence of a current account deficit even there. In Spain and
Ireland, the flow and stock imbalances started in the private sector leading to large current account deficits and
foreign debts, but once the Spanish and Irish housing sectors went bust and resulted in sharp fiscal deficits in

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ECONOMIC RESEARCH 4

part, due to the socialization of private losses the ensuing rise in public debt created a sovereign debt
sustainability problem.
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Recent Policy Actions Start to Deal With Some Stock Vulnerabilities

The recent EZ package starts to deal with some but by no means all of the stock imbalances in the EZ periphery.
First, public debt in some (Greece) but not all of the countries where it is unsustainable (Portugal, Ireland, Cyprus,
Italy) will be reduced (50% haircut on private creditors, though the July plan will have to be completely scrapped,
and the new details are lacking at this point). Second, the excessive amount of debt relative to the equity/capital of
EZ banks will be partly addressed to prevent insolvency by recapitalizing EZ banks (both in the periphery and
the core). These banks suffer from low capital ratios and potential erosion of their capital through losses, given
exposures to sovereigns, busted real estate and rising non-‐performing loans as a result of the growing recession.
But the capital needs of EZ banks, given these tail-‐risk losses, are much larger than the 100 billion of
recapitalization needs that the EZ has identified. Third, illiquidity of banks and sovereigns risks turning illiquidity
into insolvency as self-‐fulfilling bad equilibria of runs on short-‐term liabilities of banks and governments are
possible. Thus, the full allotment policy would prevent such a run on bank liabilities in principle only for
banks that are illiquid but solvent, but in practice even possibly for insolvent banks.

For sovereigns that have lost market credibility and whose spreads could blow to an unsustainable level
. Bail-‐ big bazooka
of the fin is necessary to provide time and financing
for the flow adjustment fiscal and structural to restore market confidence and reduce spreads to sustainable
levels. In each case, assumptions need to be made about whether a country is a) illiquid but solvent given financing
to prevent loss of market access, time and enough adjustment/austerity (possibly Italy and Spain); b) illiquid and
insolvent (Greece, clearly); or c) illiquid and near insolvent and already needing conditional financing given that
market access has already been lost (Portugal, Ireland and Cyprus).

But even if Italy and Spain were illiquid and solvent given time, financing and adjustment, the big bazooka that the
EZ needs to backstop banks and sovereigns in the periphery is at least 2 trillion and possibly 3 trillion rather than
the fuzzy 1 trillion that the EZ vaguely committed to at the recent summit. So, on all three counts, the recent EZ
plan falls short of addressing the stock problems of highly indebted sovereigns, the capital needs of EZ banks and
the liquidity needs of EZ banks and sovereigns; it also does little or nothing to restore competitiveness and growth
in the short run.

Critical Role of Flow Factors in Resolving Stock Sustainability Issues

To make stocks sustainable, it is crucially important to address flow imbalances, for several reasons. First of all,
without economic growth, you have a dual problem: a) The socio-‐political backlash against fiscal austerity and
reforms becomes overwhelming as no society can accept year after year of economic contraction to deal with its
imbalances; b) more importantly, to attain sustainability, flow deficits (fiscal and current account) and excessive
debt stocks (private and public, domestic and foreign) need to be stabilized and reduced, but if output keeps on
falling, such deficit and debt ratios keep on rising to unsustainable levels.

Second, restoring growth is also important because, without growth, absolute fiscal deficits become larger rather
than smaller (given automatic stabilizers). Third, restoring external competitiveness is key as that loss of
competitiveness led in the first place to current account deficits and the accumulation of foreign debt and to

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ECONOMIC RESEARCH 5

lower economic growth as the trade balance detracts from GDP growth when it is in a large and growing deficit. So,
unless growth and external competitiveness are restored, flow imbalances (fiscal and current account deficits)
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persist and stabilizing domestic and external deficits becomes mission impossible. Finally, note that, unless
growth and competitiveness are restored, even dealing with stock problems via debt reduction will not work as
flow deficits (fiscal and current account) will continue and, eventually, even reduced debt ratios will rise again if
the denominator of the debt ratio (debt to GDP), i.e. GDP, keeps on falling. Growth also matters as credit risk
measured by real interest rates on public, private and external debt, which measures the default risk will be
higher the lower the economic growth rate. So, for any given debt level, a lower GDP growth rate that leads to a
higher credit spread makes those debt dynamics more unsustainable (as sustainability depends on the differential
between real interest rates and growth rates times the initial debt ratio).

The Current Account Flow Deficit Problem in the EZ Periphery

While the issue of fiscal deficits and public debt has been overemphasized in the recent policy debate about the
problems of the EZ, one should not underestimate the role of external current account imbalances. These

periphery has suffered implies that such deficits are now not financeable in the absence of official finance. These
deficits are the result of savings-‐investment imbalances in both the private (Spain, Ireland, Portugal) and public
sectors (Greece, Portugal, Cyprus, Italy); they are also the result of the real appreciation of these countries
following a decade of declining export market share, the growth of wages in excess of productivity growth and the
strength of the euro. Some of these deficits are now cyclically lower given that the collapse of output/demand has
led to a fall in imports. But, on a structural basis, unless the real appreciation is reversed, the restoration of growth
to its potential level would result in the resumption of large and now not financeable external deficits.

So, the modest reduction in current account deficits in the periphery that has been seen since 2009 is deceptive: It
for the most part reflect an improvement in competitiveness; it is only the result of a severe and
persistent recession. Real depreciation is required to restore such competiveness while ensuring sustained
economic growth. An inability to restore competitiveness and thus growth would eventually undermine the
monetary union as private creditors are now after a sudden stop unwilling to finance such deficits. So,
eliminating the external current account deficit is as critical to restoring debt sustainability as reducing flow fiscal
deficits. And fiscal deficits are not the only explanation of the external deficits as real appreciation and loss of
competitiveness are as important, if not more important, than fiscal imbalances, in explaining such external
imbalances.

The Recent EZ Package Does Little or Nothing to Restore, in the Short Term, Growth and Competitiveness, Which
Are the Key to Sustainability

The latest economic data such as the EZ PMIs strongly suggest that the EZ not just the periphery, but also the
core are falling back into a recession. This is very clear in the periphery where some countries never got out of
their first 2008 recession, while the others are plunging back into recession after a very moderate recovery. But
even in the core of the EZ, the latest data suggest that a recession is looming.

The recent EZ package (a bigger Greek haircut, bank recaps and a levered European Financial Stability Facility
(EFSF), together with more fiscal austerity and a push toward structural reforms) does nothing to restore
competitiveness and growth in the short run. In fact, it actually exacerbates the risk of a deeper and longer
recession. Fiscal austerity is necessary to prevent a fiscal train wreck, but, in the short run (as recent IMF studies

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ECONOMIC RESEARCH 6

suggest), raising taxes, reducing transfer payments and cutting government spending (even
inefficient/unproductive expenditure) has a negative effect on economic growth, as it reduces aggregate demand
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and disposable income. Moreover, even structural reforms that will eventually boost growth via higher
productivity growth have a short-‐run negative effect: You need to fire unproductive public employees; you need to
fire workers in weak firms and sectors; you need to shut down unprofitable firms in declining sectors; you need to
move labor and capital from declining sectors to new sectors in which the country may have a comparative
advantage. This all takes time and, in the absence of a rapid real depreciation, what are the sectors in which a
periphery country has a new comparative advantage? Even necessary structural reforms like fiscal austerity
reduce output and GDP in the short run before they have beneficial medium-‐term effects on growth.

To restore growth and competitiveness: The ECB would have to rapidly reverse its policy hikes, sharply reduce
policy rates toward zero and do more quantitative and credit easing; the value of the euro would have to sharply
fall toward parity with the U.S. dollar; and the core of the EZ would have to implement significant fiscal stimulus if
the periphery is forced into necessary but contractionary fiscal austerity (which will have a short-‐term drag on
growth).

Options for Dealing with Stock and Flow Problems

Stock imbalances large and potentially unsustainable liabilities can be addressed in multiple ways: a) high
economic growth can heal most wounds, especially debt wounds given that fast growth in the denominator of the
debt ratio (i.e. GDP) can lead over time to a lowering of debt ratios; b) low spending and higher savings in the
private and public sectors can lead to lower fiscal deficits and lower current account deficits (lower flow
imbalances) that, over time, reduce the stocks of public and external debt relative to GDP; c) inflation and/or forms
of financial repression can reduce the real value of debts; the same can occur with unexpected depreciation of the
currency if the liabilities are in a domestic currency; d) debts can be reduced via debt restructurings and reductions,
including the conversion of debt into equity. The last option is key: If growth remains anemic in the EZ; if savings
lead to the paradox of thrift (a more severe short-‐term recession) and if monetization, inflation or devaluations are
not pursued by the ECB, the only way to deal with excessive private and public debts becomes some orderly or
disorderly reduction of such debts and/or their conversion into equity.

Flow imbalances are more difficult to resolve as they imply a reduction of fiscal and current account deficits that
are consistent with sustainable growth and with the restoration of competitiveness, which requires real
depreciation. To reduce external current account deficits the key to restoring competitiveness and growth you
need both decreases in expenditure (private and public) and expenditure-‐switching through a real depreciation.
Such real depreciation can occur in four ways: a) a nominal depreciation of the euro large enough to lead to a
sharp real depreciation in the periphery; b) structural reforms that increase productivity growth while keeping a lid
on wage growth below productivity growth and thus reduce unit labor costs over time; c) real depreciation via
deflation a cumulative persistent fall in prices and wages that achieves a sharp real depreciation; and d) exit from
the monetary union and return to a national currency that leads to a nominal and real depreciation. The key issue
here is as we will discuss in detail below that achieving the real depreciation via route a) is unlikely, as there are
many reasons why the euro will not weaken enough; getting it via b) may take way too long a decade or more
when the sudden stop requires a rapid turnaround of the external deficit; achieving it via c) may also take too long
and would be associated with a persistent recession, while leading to massive balance-‐sheet effects; thus the d)
option exit from EZ becomes the only available one if the other three are not feasible/desirable.

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ECONOMIC RESEARCH 7

Additionally, if growth and competitiveness are restored in short order, this is the best way on top of decreased
expenditure via fiscal austerity to reduce both the fiscal and current account imbalances as well as the relative
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ones (i.e. as a share of GDP). In other terms, fiscal austerity and structural reforms eventually restore growth and
productivity, but they are, in the short run, recessionary. Thus, other macro policies are needed to restore growth,
which is critical to make the adjustment politically and financially feasible. Therefore, macro policies consistent
with a rapid return to economic growth are the key to resolving flow problems.

Four Options to Address the Stock and Flow Problems of the EZ

Given the above analysis of the structural and fundamental problems faced by the EZ, there are four possible
options to deal with the stock and flow problems; each option implies a different future for the monetary
union. Each reduces unsustainable debts and restores growth and competitiveness and reduces flow imbalances
via a different combination of the policies discussed above

1. Growth and Competiveness Are Restored. In this first option, policies are undertaken to rapidly
restore growth and competitiveness (monetary easing, a weaker euro, core fiscal easing and the
reduction of unsustainable public and private debts in clear insolvency cases), to reduce flow deficits
and to restore private, public and external debt sustainability, all while the periphery undertakes
continued painful austerity and structural reforms. In this scenario, the EZ survives in the sense that
most members maybe with the exceptions of Greece and possibly Portugal remain in the EZ and
most members again, with the exceptions of Greece and possibly Portugal avoid a coercive
restructuring of their public and private debts. This solution requires a nominal and real depreciation
of the euro and, for a period of time, higher (lower) inflation in the core (periphery) of the EZ than the
current ECB target to restore, via real depreciation, the competitiveness of the periphery and rapidly
eliminate its unsustainable current account deficit.

2. The Deflationary/Depressionary Route to the Restoration of Competitiveness. Growth and
competitiveness are not restored in the short run as the core/Germany imposes an adjustment based
on deflationary and depressionary draconian fiscal austerity and structural reforms that, in the
absence of appropriate expansionary macro policies, makes the recession of the periphery severe and
persistent and does This
depression/deflationary path becomes politically and socially unsustainable for most but possibly
not all of the EZ periphery as it implies five-‐ten years of ever-‐falling output to restore
competitiveness via deflation and eventual structural reforms. And with output falling in the short
run and a fall in prices/wages, stock problems worsen for a while (as both nominal and real GDP are
falling) until the restoration of growth eventually takes care of the stock imbalances. Since, for most
EZ members, Option 2 becomes politically and socially unfeasible, in the absence of a path that leads
to Option 1, Option 2 evolves into Options 3 or 4.

3. The Core Permanently Subsidizes the Periphery. If Option 1 does not materialize while Option 2
becomes politically-‐socially unsustainable, the only other way to avoid Option 4 (EZ break-‐up) is not
just via a reduction of the unsustainable stocks of liabilities in the periphery (a capital levy on the core
of creditors), but also via a permanent subsidization of the uncompetitive periphery by the core.
Since the lack of a restoration of growth/competiveness implies a permanent external deficit (trade
deficit) in the periphery with a trade surplus in the core that implies an unsustainable current account
deficit in the periphery, the only way in which the core can prevent the periphery from exiting the EZ

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ECONOMIC RESEARCH 8

flow deficit problem) is to make
a unilateral permanent yearly transfer payment (of the order of several percentage points of core
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GDP, possibly as high as 5% of GDP) to the periphery to prevent the trade deficit from turning into an
unsustainable current account deficit that in turn leads to the accumulation of even more
unsustainable external debt. Such a unilateral transfer sustains the GNP of the periphery while its
GDP remains permanently depressed as competitiveness is not restored. So, stock problems are
addressed via repeated restructurings, extensions and haircuts of privately held debt (bonds) and
bilateral/multilateral loans as well as via recapitalizations of banks that include some conversion of
debt into equity. Meanwhile, flow problems are addressed via a permanent yearly subsidy to the
periphery from the core.

4. The EZ Experiences Widespread Debt Restructurings. Members of the periphery react to the Option
2 (depression/deflation) that is currently imposed on them by Germany and the ECB by, first, losing
market access (or not regaining it) and are thus forced, once official finance runs out (because of
political and/or financial constraints in the core), to coercively restructure their public and also their
private debts (say, of banks and financial institutions). Even such a debt reduction is insufficient to
restore growth and competitiveness as it partially deals with stock problems, but does not deal with
flow problems. If, then, the flow problem is not resolved via a permanent subsidization of the income
of the periphery by the core (Option 3), then the only other way to restore growth and
competitiveness is via exit from the monetary union and a return to the national currency. The EZ can
survive the exit of its smaller members (Greece, Portugal, Cyprus), but if debt restructurings and the
exit of Italy and/or Spain become necessary/inevitable, the EZ effectively breaks up, with only a small
core Germany and a few core members remaining in a smaller and much damaged monetary
union.

An Assessment of the Likelihood of the Four Options

Option 1: Most Desirable But Quite Unlikely as Contrary to the Goals and Constraints of Germany/the ECB

Which one of these four options is most likely? Option 1 appears the most desirable as it leads to the survival and
success of the EZ. However, it is not necessarily the most likely option as it would imply radical, rapid and
presumably unacceptable changes in macro-‐policy.

First, the ECB would have to reverse its policy tightening and aggressively cut rates; even that would not be
sufficient as aggressive quantitative easing (QE) would be necessary to restore growth and provide unlimited
lending of last resort (LOLR) to sovereigns such as Spain and Italy that are possibly illiquid but solvent if given
enough time and liquidity to resolve their problems. Even traditional QE would not be sufficient as unconventional
credit easing may be necessary to restore credit growth to smaller firms and households subject to a credit crunch.
This is obviously not acceptable to the ECB and Germany as it would require a radical change (maybe via a treaty
change) to the formal mandate (the bank is currently supposed to only pursue the goal of price stability). The
ECB and eventually Germany as a recap of the ECB would fall to Germany/core would also take a significant risk
in becoming (for a while) the LOLR for Italy and Spain, which may turn out even with massive liquidity to be not
just illiquid but also insolvent (there are many future paths via which the latter could happen).

Second, the value of the euro would have to fall sharply compared with current levels, possibly toward parity with
the U.S. dollar to reverse the loss of competitiveness of the periphery. This would imply that inflation would rise in
the core starting in Germany for a number of years above 2% to allow the real depreciation of the periphery to
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ECONOMIC RESEARCH 9

occur. being politically acceptable to Germany and the ECB. Also, with Germany being uber-‐
competitive and with a large external surplus, while the U.S. dollar needs to a weaken given the large U.S. current
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account deficit, it is not obvious that the euro would fall as sharply as the periphery needs, unless the ECB
aggressively pursues QE and credit easing and jawbones the euro down with verbal and actual intervention: All
very unlikely outcomes given the current mandate and the German/ECB goal of restoring the periphery

Third, the core would have to accept and implement a fiscal stimulus to compensate for the recessionary effects of
the fiscal austerity of the periphery. But Germany and the core are vehemently against back-‐loaded fiscal austerity
let alone fiscal easing of the type that even the IMF is now suggesting to them. Germany/the core is of the view
that the problems of the periphery were self-‐inflicted even when private imbalances (like in Spain and Ireland)
rather than public ones were at the core of financial difficulties. So, austerity and reform are viewed by the core as
a must for both the periphery and also for the core.

Option 2: Socially-‐Politically Unacceptable as Implies a Persistent Recession-‐Depression in Most of the Periphery

Option 2 is the type of adjustment that the ECB and Germany would like to impose on the periphery, but it would
be socially and politically unacceptable for most. It is thus not a stable equilibrium but rather an unstable
disequilibrium that would eventually lead to Options 3 or 4. Since fiscal deficits are excessive, they need to be
rapidly reduced via front-‐loaded austerity to make public debts sustainable. Current account deficits will be partly
reduced via the reduction of public dis-‐savings. The rest of the external imbalance will be corrected via deflation
(internal devaluation) and via accelerated structural reforms that increase productivity growth, while keeping a lid
on wage growth below such higher productivity growth will progressively reduce unit labor costs and restore
external competitiveness.

The problems with the German/ECB solution to the growth/competitiveness issue are multiple. First, fiscal
austerity is necessary, but if implemented by the entire EZ it makes the periphery recession worse, deeper and
longer and thus undermines the restoration of growth that is necessary to make the debts sustainable. Also, such
recession damages attempts to reduce fiscal deficits; and it improves external balances only temporarily via a
compression of imports, not via a true restoration of competitiveness; structural external deficits mostly remain.

Second, reducing unit labor costs via accelerated reforms that increase productivity growth while keeping a lid on
wage growth below such rising productivity growth is easier said than done. It took 10 to 15 years for Germany
to achieve its reduction of unit labor costs via that route. And since German unit labor costs have fallen by 20%
since the inception of the EZ, while they have risen by 30% in the EZ periphery, the unit labor cost gap between
Germany and periphery is now about 50%. So, if the EZ periphery were to accelerate reforms that actually depress
output in the short run, the benefits will start to show up after five years or so; and no country can accept five
years of recession or depression before it returns to growth. Also, a reduction in unit labor costs via a rise in
productivity growth above positive wage growth as in Germany in the past 15 years is politically more
feasible as it is associated with growth rather than recession than a recessionary adjustment where wages need
to fall in nominal terms as productivity growth remains stagnant while output stagnates for a number of years.
Given the nominal downward rigidity of wages and prices, outright deflation is extremely hard to achieve in the
absence of a severe and persistent depression.

Third, deflation/internal devaluation is not politically-‐socially feasible if it leads as is likely to persistent
recession. Deflation a 5% fall in prices and wages for five years leading to a cumulative compound reduction of

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ECONOMIC RESEARCH 10

prices and wages of 30% that undoes the loss of competitiveness of the periphery would be most likely
associated with a continued recession for five more years, likely turning into a depression.
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The international experience of
to a real depreciation and, after three years of an ever-‐deepening recession/depression, it defaulted and exited its
currency board peg. The case of EZ periphery:
Output fell by 20% and unemployment surged to 20%; the public debt was unlike in the EZ periphery negligible
as a percentage of GDP and thus a small amount of official finance a few billion euros was enough to backstop
the country without the massive balance-‐sheet effects of deflation; and the willingness of the policy makers to
sweat blood and tears to avoid falling into , for a while, unlimited (as opposed
to the EZ periphery unwillingness to give up altogether its fiscal independence to Germany); and even after
devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious
and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary
austerity is coming to a boil in the EZ periphery).

The other cases of successful reductions of large external and fiscal deficits and debts in the European member
states in the 1990s Belgium, Sweden, Finland, Denmark, etc. are just example as they
occurred against a background of growth (not the current EZ recession), falling interest rates as expectations of
EMU led to convergence trades (not the current blowing up of sovereign spreads and loss of market access) and, in
some cases, via nominal and real depreciations within the flexible terms of the European Monetary System (not
the rigid constraints of a monetary union where there is no national currency and the value of the euro remains
excessively strong).

Some EZ periphery members notably Ireland are undergoing a degree of internal devaluation, but it is too slow
and small to rapidly restore competitiveness: A fall in public wages may, in due course, push down private wages in
traded sectors and eventually reduce unit labor costs.

Finally, the deflation route to real depreciation even if it were politically feasible makes the private and debt
unsustainability problem more severe: After prices and wages have fallen 30% after a painful deflation, the real
value of private and public debts would be 30% higher, making the case for a sharp reduction in unsustainable
debts even more compelling.

Some EZ countries notably Ireland may have a better chance of restoring their competitiveness via internal
devaluation than others Portugal, Greece, Cyprus. Ireland has a large and productive manufacturing base as
two-‐thirds of its manufacturing industry is owned by multinational firms many in tech or high-‐value-‐added
sectors that made a lot of FDI in Ireland in the past two decades to create an industrial base in a low corporate
tax economy for their European and international production activities. So, Ireland, with some difficulty, could
regain its competitiveness in due time if the fiscal adjustment more rapidly leads to a change in the relative prices
of traded to nontraded goods.

But, in the case of Greece, Portugal and Spain, the problems of competitiveness are much more chronic and un-‐
resolvable without a nominal currency depreciation: They have permanently lost export market shares in labor
intensive and low-‐value-‐added sectors textile, apparel, leather products, light labor intensive manufacturing to
EMs -‐value-‐added
tech industries of Ireland, for example. Also, in these periphery countries (unlike in Ireland), productivity growth

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was mediocre even in the years of positive economic growth and restoring comparative advantage without a sharp
and rapid real depreciation looks less likely to be achievable.
Page | 11
Spain and Italy are in between Ireland on one side and Greece/Portugal/Cyprus: They experienced as much of an
increase in unit labor costs as the rest of the periphery (especially Spain) and they have permanently lost export
market share in traditionally labor-‐intensive sectors. Italy has implemented more structural corporate
restructuring than Spain which restored some competitiveness in higher-‐value-‐added sectors because Spain,
growing rapidly during its unsustainable real estate bubble, had little incentive to improve the competitiveness of
its traded sector. Also, until recently, Italy did not have the unsustainable current account deficit of Spain as its
private saving compensated for the dis-‐savings of the public sectors. Spain, instead, faces a massive stock of
private sector foreign liabilities held by households, corporate firms, banks and financial firms that are not
easily re-‐financeable as an external sudden stop has now occurred. But, in the past year,
deficit has now significantly increased, despite depressed economic activity: A worrisome signal of a loss of
competitiveness.

Option 3: Not Acceptable to the EZ Core as it Implies Permanent Subsidies to a Large Part of the Periphery, I.e. a
Transfer Union Rather Than a Fiscal Union

Option 1 implies a policy adjustment that is biased against Germany/the core/the ECB as it implies that these
agents/countries take on significant credit risk and accept higher inflation to adjust inter-‐EZ real exchange rates;
thus, it is unacceptable to them. Option 2 implies that all the burden of adjustment is born by the periphery in
terms of many years of fiscal belt-‐tightening and, worse, a deflationary recession that could turn into a depression.
Thus, it eventually becomes unacceptable to the EZ periphery. Then, the periphery would be tempted to
unilaterally reduce its debt burdens via coercive debt restructuring first and via exit from the EZ next, as exit, on
top of debt reduction, becomes necessary to restore competitiveness and growth.

Then, if the EZ would want to prevent a disorderly break-‐up of the EZ, it would not only have to accept a reduction
of the unsustainable debts that imposes a capital levy on the core creditors (something that becomes
unavoidable to resolve the stock problems), but, more importantly, it would also have to permanently subsidize
the chronic trade deficits to prevent such deficits from causing unsustainable current account deficits
that are no longer financeable. Thus, a unilateral permanent fiscal transfer by the core to the periphery would be
necessary to boost the periphery GNP given its depressed GDP and maintain a current account balance in both
the core and periphery, despite the persistent trade imbalances between the two regions. If Germany/the EZ core
were to run a permanent trade surplus of say 4-‐5% of GDP relative to that of the EZ periphery, then a permanent
yearly transfer of up to 4-‐5% of GDP from the core to periphery would be necessary to bribe the periphery to
stay in the EZ rather than exit the monetary union.

Such unilateral transfers from rich to poor regions are not very common,
the context of nation states where there is a political union. In Italy, the north has transferred income to the south
Similarly, West Germany has paid for unification with East
Germany with massive transfer payments and government spending on reconstruction that have lasted for over 20
years now and that are not over yet (like the still-‐existing income tax surtaxes to pay for massive reunification
costs). In Australia, the fiscal system permanently transfers income to Tasmania, which is the Australian
equivalent in terms of poverty/low incomes of the Italian Mezzogiorno or East Germany. But even in the
context of unified nation states with a common national identity, such permanent transfers become politically and
socially unacceptable as the rich regions resent such transfers and eventually revolt against them: In Italy, for

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example, political movements representing the rich north (notably, the Lega Nord) have become influential and
are now imposing a form of fiscal federalism that will, over time, significantly reduce transfers from the north to
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the south. And concerns are now being expressed that such fiscal reform will lead to a sharp political backlash in
the south; even, in the extreme, threats of secession or national breakdown. So, permanent unilateral transfers of
income from rich to poor regions become politically problematic even in a unified political union with a
homogenous national identity.

This suggests that the idea that Germany or the core of the EZ would accept a permanent several percentage
points of its GDP transfer of its income to the periphery as a condition for the periphery not exiting the EZ runs
against political trends and is extremely unlikely to occur. The EU has a system of structural payments from rich to
poor states (southern and new eastern European members), but these transfers are relatively modest (less than
0.5% of the GDP). Ramping them up by a factor of 10 to bribe the periphery into staying in the EZ would be
totally unacceptable politically and otherwise to Germany and the rest of the core. Also, it would not make
economic sense: Until now, the excess of income (spending) over spending (income) in the core (periphery) that
has taken the form of a current account surplus (deficit) in the core (periphery) has been financed with debt that,
in principle, is an asset of the core and should be paid back with interest by the periphery over time.

Now, instead, the core would have first to accept a capital levy on its accumulated assets over the periphery (its
foreign assets accumulated through decades of current account surpluses) to allow the reductions of the
unsustainable foreign private and public debts. The EZ core is now grudgingly accepting some of this
capital levy (losses on EZ creditors coming from the debt reduction in Greece), but similar capital levies are
unavoidable for the debts of Portugal, Ireland and Cyprus, and may become unavoidable even for Italy and Spain.

But even this much larger capital levy would not be enough as the persistent chronic trade deficit of the periphery
would next have to be financed not via debt-‐creating flows, but rather unilateral transfers within a currency union.
Providing a system of vendor financing from the core to periphery may have made sense for the core for a while to
sustain its export and GDP growth even if it eventually leads to a capital levy when the debtor is unable to pay. But
a system of unilateral transfers from the core to periphery where the excess of spending over income of the
periphery is financed by permanent grants not loans
core: It is a permanent reduction of income and welfare and consumption for no sensible reason apart from the
vague goal of keeping the EZ together.

The discussion above suggests that the usual recent argument i.e. that the EZ needs to become a fiscal union to
survive its crisis is partially wrong and confusing. There is a substantial and critical difference between a fiscal
union and a transfer union. In a fiscal union, there is true risk-‐sharing and no permanent transfer of income from
one state/region to another. Where revenues and spending are partially shared at the federal level, there is risk-‐
sharing: When an idiosyncratic shock occurs in one region (such as a recession in one state of the union, but not in
other states), risk-‐sharing implies that revenues and transfers/spending are adjusted to reduce the effect of that
temporary state-‐specific shock to the output (GDP) of that state on its income (GNP). If such state-‐specific shocks
are random sometimes hitting one region/state, sometimes hitting another region/state of the union the
worse-‐off region subject to the negative output shock gets partially and temporarily subsidized by the region/state
that is temporarily better off. And over time like in any actuarially fair insurance scheme mutual insurance
smoothes shocks to income that are driven by shocks to output. No region/state permanently subsidizes another
one. This is a fiscal union where risk is pooled and shared.

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A transfer union is a very different animal: it is not a fiscal union aimed at sharing, insuring and smoothing
temporary regional output shocks. It is instead a mechanism that uses fiscal resources taxes, transfer payments
Page | 13
and public spending to permanently transfer income from richer region/states to poorer regions/states. Transfer
unions are politically problematic even in unified nations that are political unions and are nationally homogenous.
They are much more problematic when a political union does not exist and where the arguments for a permanent
transfer union are not acceptable. For a German to accept a permanent transfer of her income to the Greeks as a

because they breed moral hazard. Even if one could make the argument
that initial differences in per-‐capita income between different regions/states of an economic union were explained
by exogenous factors different from endogenous policy/economic efforts, the existence of a permanent transfer
union would obviously breed over time moral hazard. The weak/poor region might not want to make much
economic/policy/fiscal effort to improve its economic/fiscal conditions as it is permanently subsidized by the richer
region.

Moral hazard is thus the reason why fiscal unions come with binding rules that limit the risk attached to the
transferee being fiscally undisciplined, to prevent a fiscal union becoming a transfer union. This is also the reason
why the current efforts of Germany/the core EZ to help the periphery are subject to strict fiscal and structural
conditionality: Only if the periphery does significant and painful fiscal austerity and structural reforms, will the core
help the periphery to overcome its temporary fiscal and financial problems. This is also the reason why any inter-‐
EZ debate on future quasi or full fiscal union comes with the express request by Germany/the core for binding
fiscal rules (balanced budgets over time, balanced budget amendments, sanctions against deviant states) to
prevent such a fiscal union from turning into a transfer union.

In conclusion, Option 3 is highly unlikely and undesirable for the core EZ as it would imply the creation of a transfer
union, rather than a fiscal union. But if Option 2 deflationary depression is unacceptable to the periphery, only
a transfer union prevents the periphery from being tempted to avoid a persistent recession, from considering
exiting the monetary union and restoring its growth and competitiveness via a return to its national currency.

Option 4: Widespread Debt Reductions and Eventual EZ Break-‐Up Becomes the More Likely Outcome as the
Other Three Options Are Not Likely or They Are Not Desirable or Sustainable

The core of the EZ is unlikely accept a symmetric adjustment Option 1 that restores competitiveness and
growth in the periphery via monetary and fiscal easing and a weaker euro that implies higher inflation for a period
of time in the core, a persistent LOLR role for the ECB and significant credit risk for the core if some periphery
members end up being both illiquid and insolvent. It is instead pushing for Option 2, recessionary deflation in the
periphery, which is not politically acceptable in most of the periphery. Then, the only way to keep the periphery in
the EZ becomes both a capital levy on the core creditors to make the debts of the periphery sustainable and, on
top of that, unilateral transfers in the form of a transfer union that permanently subsidizes the depressed
income of the EZ periphery (caused by the permanent loss of competitiveness that remaining in the EZ implies).

But such a transfer union is not politically or economically acceptable to the core. Then, the only other option is
first a capital levy imposed by the periphery on the core in the form of a reduction of unsustainable foreign
private and public liabilities to reduce such unsustainable debt. But even that debt reduction is not sufficient to
restore competitiveness and growth. And if competitiveness cannot be restored via Option 1 (a much weaker euro),
or Option 2 (depressive deflation or too-‐slow structural reform) or Option 3 (where the incipient permanent loss of

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4 options to address the eurozone's stock and flow imbalances the rising risk of a disorderly break-up - november 1 2011 (1)

4 options to address the eurozone's stock and flow imbalances the rising risk of a disorderly break-up - november 1 2011 (1)

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